Pensions - a practical choice

The Report from the Pensions Commission makes clear that we all have to think more about our income in retirement and take action if we can. Six million people who are still at work are being given a chance to do just that. Sometime before Christmas they will get a letter from the insurance industry about their pension. If you get one, don’t throw it away unread. Making the right choice could make you better off when you do retire.

The letter and accompanying factsheet have been produced by the Association of British Insurers (ABI). They are being sent to everyone who is paying into a personal or stakeholder pension and has chosen to have some of their National Insurance contributions paid into that pension. It’s called ‘contracting out’ because you give up your rights to the additional earnings related state pension. Instead, part of your National Insurance contributions – called a ‘rebate’ – are passed on to your personal pension provider.

Contracting out into a personal pension began in 1988. The idea was that a pension linked to the stock market would give you more money in retirement than you would get from the State Earnings Related Pension Scheme (SERPS). It was widely recommended by financial advisers who earned commission on the National Insurance contributions that were now paid into a personal pension. The Government of the day supported the move too. The calculation of how much of your National Insurance contributions to transfer was done generously – and initially an extra 2 per cent was added to boost your personal pension further.

In the heady days of the 1990s the stock market seemed a better gamble than the State. But over the last few years, investment returns on pension funds have been poor and since April 2003 the National Insurance rebates that are paid into a personal pension are calculated less generously. They are now supposed to be ‘neutral’. In other words, the pension you would get by paying this part of your National Insurance contributions into the personal pension should be the same as the one you would get if you stayed in SERPS – which has now been renamed State Second Pension.

Not neutral
Of course, if that was true the decision would relatively unimportant – you would end up with the same pension whatever you chose. But the rebates are not necessarily ‘neutral’ – especially for people approaching retirement – and the decision to remain contracted out or to contract back in to the State Second Pension could make you better off – or poorer – in retirement.

Any projection of returns on a personal pension depends on assumptions about the future. In this case the Government Actuary, the mathematician who advises on pensions and their costs, assumes that investments in pension funds will grow by 2 per cent a year above the rise in earnings each year – around 4.5 to 5 per cent. If investments achieve that growth of 6.5 to 7 per cent a year, then the personal pension earned by contracting out should be equal to the State Second Pension you would get if you stayed contracted in. If investments grow by less than that then the state pension will be better. If they grow by more then the personal pension will be better. So the decision partly depends on your faith in the growth of investments. The calculations also assume that the charges on your pension are 1 per cent a year. If yours are more that tips the balance towards the state scheme.

Practical
There are also some practical considerations about which to choose because the rules about a personal pension and the State Second Pension are different.

• Age: You can draw this part of a personal pension, based on contracted out rebates, at 60. That age will go down to 50 from 2006 and four years later will rise to 55. If you draw your personal pension early it will of course be much less per year. You cannot draw your State Second Pension until 65 (60 for a woman until 2010 and then rising to 65 by 2020). However you can defer your state pension beyond pension age and get a guaranteed increase in it when you finally do draw it.

• Lumpsum: From April 2006 you can take a quarter of this part of your personal pension fund as a tax-free lump sum, though that will reduce your pension. There is no tax free cash with State Second Pension.

• Inheritance: If you die before pension age, your spouse can be paid a pension from your fund or it may form part of your estate. You cannot leave your State Second Pension to anyone – but your spouse may get part of your pension when you die.

Trust
If you contract out you are taking a gamble on the growth in investments. But if you contract back in to the State Second Pension you are trusting future governments not to change the rules – again. The amount of pension paid has been changed three times since SERPS began in 1978.

Adrian Boulding, Pension Strategy Director at the insurer Legal & General, says it is a personal choice. "Do you personally feel more comfortable about real money in your account with all the excitement of the ups and downs of the stock market? Or with a government promise that depends on future taxpayers to meet it? It is a philosophical matter."

No advice
With such a difficult question you might think the best person to go to for help would be a financial adviser – perhaps the one who sold you the personal pension and encouraged you to contract out of SERPS in the first place. Unfortunately your adviser will be unwilling to help you with the decision beyond explaining the information in the leaflet from the ABI and telling you that it is up to you to decide. They will probably tell you the decision is ‘financially neutral’ – in other words you are neither likely to make or lose money by the choice. Cynics might put this reluctance down to the fact that there is no commission for them whatever you choose. It also seems that many advisers are concerned that if they did give advice, customers may come back in future to claim they were ‘mis-advised’ and seek compensation.

The consumer organisation Which? believes this whole exercise is as much aimed at preventing future mis-selling claims as informing people of their rights. Teresa Fritz is its Principal Researcher.

"The fact the industry have taken it upon themselves to issue this factsheet indicates they believe there is a serious problem with people who are currently contracted-out of the state pension scheme into a personal pension. But it is difficult for us to believe that the financial services industry would volunteer to undertake an initiative of this size without some sort of underlying motive. Which? believes this factsheet may be a pre-emptive strike by the industry against any future mis-selling claims."

What you should do
Fortunately for most Saga readers the decision is simple. Although the Government wanted to make the rebates ‘neutral’, it realised that to do so would be very expensive once people were in their fifties. So it cut the rebates and once women reach their early fifties and men reach their late fifties the rebates are less than neutral. In other words the amount paid into your personal pension will buy you a lower pension that you would get from State Second Pension. So at that age you should contract back in.

Even for people younger than that there is a simple way to bypass the impossible choice. There is a fundamental principle of investment – do not put all your eggs in one basket. The State Second Pension and a personal pension are very different ways of getting a bit extra in retirement. So if you can’t decide who to trust – market or state – why not spread your risk by paying into both? You can do that by continuing to pay into your personal pension but also pay into the State Second Pension as well by contracting back in. Belt and braces. That way your retirement trousers are less likely to end up round your ankles.

Anyone paying into a personal or stakeholder pension is free to contract back in to the State Second Pension. But the change will only happen from the start of the current tax year or the start of the next tax year – you must choose. So if you get the form in by 5 April 2005 you can contract back in for this tax year 2004/05. Your pension provider or IFA will give you the form CA1543.

Contracting out does not affect your basic state pension of around £80 a week which you get in full after you have worked and paid full National Insurance contributions for about 40 years. It only affects the ‘additional pension’ which is related to your earnings.

Company schemes
If you are paying into a pension scheme run by your employer you may also be ‘contracted out’ of the State Second Pension. But it is much harder to contract back in. If the scheme promises you a pension related to your salary – called a ‘final salary’ or ‘defined benefit (DB)’ scheme – then you cannot contract back into the state pension. If you pay into what is called a ‘money purchase’ scheme (sometimes called a ‘defined contribution’ or DC scheme) then it may allow its members to contract back in – or it may not. If yours does not then all you can do is lobby the trustees of the scheme to change the rules.

More information
If you do not know if you are contracted out or not you the National Insurance office helpline should be able to tell you on 0845 915 0150. The information may also be on the annual statement from your pension provider – but in many cases it will not be.

December 2004

e-mail Paul Lewis on paul@paullewis.co.uk